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April-May, 2011

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"There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million can diagnose." - John Maynard Keynes


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mkMichael J. Kosares, the author of these articles, has more than 40 years experience in the gold business. He is the founder and executive director of USAGOLD (both the website and gold brokerage service), the author of three books on the gold market, and the editor of "News & Views, Forecasts, Commentary & Analysis on the Economy and Precious Metals," the firm's client letter. He has written numerous magazine and internet essays and is well-known for his ongoing commentary on the gold market and its economic, political and financial underpinnings.

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International Turmoil
How the physical gold market is likely to be affected

by Peter A. Grant

The first quarter of the new year has been a tumultuous one, marked by geopolitical unrest in North Africa and the Middle East, major natural disasters in New Zealand and most recently in Japan, and of course ongoing economic turmoil throughout much of the industrialized world. This has resulted in rather extreme market volatility, amid fits of risk aversion associated with broad-based uncertainty about the likely impact of recent events.

Most importantly, our hearts go out to the people of the world who are suffering right now; be it due to political repression, natural disaster or economic hardship. However, in this increasingly interconnected world, it is important to remember that events on the other side of the world can indeed have a significant impact right here at home. Faced with the harsh reality that global markets have no sympathy, savers and investors the world-over need to make decisions that protect their interests and their wealth.

As you contemplate the best steps to take to preserve your wealth in light of global events, you may be feeling overwhelmed by all the information and conflicting reports so readily at our fingertips in this modern age. Sometimes its best to step back, take a deep breath and realize that frequently, the most obvious answer is the right answer. But before I delve into how investors are likely to behave in this particularly trying market environment, let me lay a little groundwork.

There is a great deal going on the world right now, all of it is worthy of discussion, but in this issue we will deal with the two major front-burner issues: Japan and the Middle East/North Africa.

Japan

While the immediate situation in Japan is a fluid one -- changing day by day and in some instances hour by hour -- it is above all else a humanitarian disaster. As of this writing, the death-toll is well over 6,000, with more than 10,000 people still unaccounted for. As recovery and rescue efforts continue, Japan is struggling mightily to contain the nuclear disaster that is a by-product of the earthquake and tsunami. We wish them godspeed in those efforts and as we consider potential prudent moves on our own behalves, we encourage our clients and friends to offer what they can to the relief efforts if they are in a position to do so.

When all is said and done, I have no doubt that Japan will rebuild and ultimately recover from the devastation. However, it may prove to be a long and rocky road for a country already saddled with massive debt and an ever-worsening demographic problem. While the country’s debt-to-GDP ratio is in excess of 200%, Japan is a country of savers and the majority of that debt is held internally. In that respect, Japan is probably in as good a position to absorb the negative economic impacts of the earthquake as any industrialized nation. However, a rapidly aging population means the mounting debt burden is going to be shouldered by fewer and fewer working-age Japanese as time progresses.

Additionally, Japan’s export-driven industrial economy is largely reliant on raw materials and energy imported from abroad. More than a third of Japan’s electricity comes from nuclear power, which has been a strategic priority since the oil crisis of the 1970s. In the months and years ahead, the people of Japan are going to have to come to grips with the trade-offs associated with nuclear power. If they decide that their location within the Pacific ring of fire makes nuclear too risky, it will leave their economy overly -- and dangerously -- dependent on the import of carbon-based fuels. Having their future even more dependent than it already is on volatile energy markets is not an enviable position to be in.

Oil_Gold

The relationship between gold and oil is well-known, but since the unrest in the Middle East/North Africa began, that correlation has been particularly tight.

Meanwhile the crisis in Japan has prompted countries around the globe to review their nuclear policies. Industrial giant Germany vowed to close its seven oldest nuclear power plants, which would reduce its nuclear-powered electricity generation by about a third. Even China, not known for being timid in pursuing infrastructure projects, has suspended all approvals for nuclear power plants. You can imagine the long-term implications for energy prices as competition for increasingly scarce fossil fuels heats up.

Japan is the third largest economy in the world, a primary driver of the global economy. Nonetheless, Japan has struggled with anemic economic growth for decades, despite a zero interest rate policy (ZIRP) and quantitative easing (QE). Makes one wonder why the United States is pursuing the very same policies and seems to be expecting different results (more on that later). So the rest of the world is understandably concerned that the disaster will not only lead to a recession in Japan, but may well weigh on the nascent recoveries elsewhere in the world, including the one right here in America.

In an effort to prevent a liquidity crisis and in the hope of mitigating the recession risk, the Bank of Japan (BoJ) acted swiftly and decisively, flooding the market with yen. The BoJ also pledged “powerful monetary easing”, but with interest rates already at zero, further boosts to the money supply and additional asset purchases are really the central bank’s only weapons. Interestingly, despite all the liquidity and loose policy talk, the yen rose dramatically against most currencies amid talk of the carry trade unwind and yen repatriation. In the face of a major catastrophe, the yen surged to a new all-time high against the dollar.

Think about that. A major natural disaster. An ongoing nuclear disaster. The threat of major economic turmoil stemming from both, and the BoJ’s primary concern ends up being yen appreciation. On Friday, March 18 the G-7 intervened jointly in the foreign exchange market for the first time in a decade...and they were selling yen. It pretty much drives home the point about ‘uncertainty’. As governments around the world intervene in various ways in order to override organic market forces, it creates a whole new set of risks in the process -- some known, but many unknowable.

North Africa and the Middle East

What began as a food price riot in Tunisia has grown into unprecedented regional geopolitical upheaval. Long-ruling strongmen in both Tunisia and Egypt were ousted in a matter of weeks by popular uprisings. While it remains to be seen if the new governments in these countries will prove to be an improvement or not, those early successes prompted similar movements throughout the region: in Algeria, Syria, Jordan, Yemen, Bahrain and Saudi Arabia, among others.

Then of course there is Libya, where protests seeking to unseat autocratic ruler Muammar Gadaffi have turned into an all-out civil war. After weeks of dithering, which brought pro-Gadaffi forces to the brink of victory, the international community finally decided to act. On March 17 the UN Security Council authorized "all necessary measures" short of a ground offensive to halt Gadaffi’s attacks on the rebels.

So the question now becomes: Is the West’s action too late? And if we’re not too late, are we actually fostering stability in the region, or are we making things worse? Only time will tell.

The Middle East and North Africa are home to more than 50% of the world’s known oil reserves. It has been noted -- with a fair amount of concern -- that three of the last five global recessions have been the result of energy price spikes stemming from conflicts in the Middle East. Oil prices have been on the rise throughout most of the year, reaching 30-month highs in February. The prospect of ongoing -- and perhaps widening -- instability in the region is likely to keep crude oil underpinned for some time to come.

The Implications

Higher energy prices will drive inflation expectations higher, elevating risks to growth in the process. Higher food prices in particular will further stoke the geopolitical unrest in oil producing nations, increasing the likelihood of disruptions to the crude supply. It becomes a vicious cycle. Japan is particularly vulnerable to energy risks now for reasons we’ve already discussed, but the U.S. remains quite vulnerable as well.

Monetary officials in the United States are undoubtedly playing the same “what if” game we are. Do events in Japan threaten to trod on the latest “green shoots” of a U.S. recovery? If Japanese investors do in fact start repatriating their capital en masse, what are the implications for the U.S. Treasury market? With Treasury holdings of $885.9 bln, Japan remains the second largest foreign holder of U.S. debt. If they reduce participation in bond auctions, or worse yet start selling bonds to raise funds for rebuilding, the Treasury Department is going to potentially have both supply and demand problems that will put upward pressure on rates. The pricing of this risk has likely contributed to the rise in the yen and added further weight to the dollar.

It is likely that only the Fed would step-in to fill the demand void and absorb any excess supply if Japan where to turn inward. In recent months, the Fed has already surpassed both Japan and China to become the largest holder of our debt. Speculation that the Fed will extend its quantitative easing campaign beyond the scheduled end of QE2 in June has escalated in light of the recent events in the Middle East and Japan.

One thing we do know from history is that higher energy prices do not bode well for the U.S. economy. In our still-weakened state in the wake of the financial crisis we are especially susceptible: encumbered by huge deficits, high unemployment, a moribund housing market, budget battles, a looming fight over the $14.294 trillion debt ceiling, and the potential for a government shut-down. An oil shock on top of all that just might be the proverbial straw that breaks the camel’s back.

Faced with rising price risks and interest rates already at zero, like the BoJ, the Fed’s options are limited. And the onus is indeed on the Fed as our Representatives in Washington squabble over tens of billions of dollars when we have a multi-trillion dollar problem on our hands. Even the chairman of the Joint Chiefs of Staff, Admiral Michael Mullen has weighed in, calling the growing national deficit the “biggest threat to our national security.”

Where to turn

Historically, in times of uncertainty and turmoil, investors have moved out of risky assets into “safe-havens” like cash, government bonds and of course gold. Arguably some of the traditional safe-havens of the past -- most notably U.S. Treasuries and the dollar -- have been severely diluted due to the proliferation of supplies.

Look at the price action of the dollar index as the Middle East and North Africa became embroiled in unrest. Note the absence of a dollar bid following the Japanese earthquake and tsunami. It would seem that the greenback has lost its safe-haven status entirely, as it hurdles relentlessly toward losing its status as the global reserve currency as well. The long-term downtrend in the dollar appears poised to re-exert itself in the face of a myriad of risks, both foreign and domestic.

Meanwhile gold has held up remarkably well, save for an initial bout of deleveraging -- primarily associated with the selling of paper representations of gold -- which moved the yellow metal a mere 4% off its recently established all-time high. In a deleveraging event, it is generally physical buying that establishes support. Gold’s safe-haven status is intact and the underlying trend is further supported by gold’s well-established roles both as an alternative currency and the traditional hedge against inflation.

Demand for physical gold so far this year has been described as “explosive” and “voracious”. There is little to indicate the quest for appropriate adjectives will end anytime soon, and in fact recent global events may spur even more robust global demand in an environment of tightening supply.

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Peter Grant is USAGOLD's resident economist and a well-known analyst globally in the forex and precious metals markets.

Short and Sweet

  • 70% of the U.S. government debt is being purchased by the Federal Reserve on an annu alized basis. So says Bill Gross, founder of Pimco, the world’s largest bond fund. Pimco has sold ALL of it U.S. Treasuries holdings.
  • Similarly, renowned Wall Streeter Carl Icahn is returning investor funds saying he no longer wanted responsibility for other people’s money. “While we are not forecasting another market dislocation,” Icahn said, “this possibility cannot be dismissed. Given the rapid market run-up over the past two years and our ongoing concerns about the economic outlook, and recent political tensions in the Middle East, I do not wish to be responsible to limited partners through another possible market crisis.” That’s one of those statements where the first part is cancelled by the second.
  • Admiral Mike Mullen, chairman of the Joint Chiefs of Staff, says that the national debt is “the biggest threat to U.S. national security. “I was shown the figures the other day by the comptroller of the Pentagon that said that the interest on our debt is $571 billion in 2012,” said Mullen. “That is, noticeably, about the size of the defense budget. It is not sustainable.” And all the Congress could shave off the massive $1.6 trillion deficit was a paltry $6 billion. Who’s kidding whom when comes to controlling spending?
  • Viet Nam’s central bank is proposing a ban on gold trading in that country. The central bank said that the elimination of gold ownership makes sense because it adds to their deficit and because the government “is rolling out measures to tame inflation.” If the central bank were truly confident in its policies to tame inflation, it wouldn’t be worried about gold demand among its citizenry..........Not to be accused of playing favorites, the Vietnamese government has also banned trading in U.S. dollars.
  • Commercial banks in Italy, who each own a portion of the country’s 2451 tonne gold reserve, are pushing for those holdings to be marked to current market prices. The move would add value to their sagging balance sheets. Italy holds the world’s fourth largest stash of gold behind the United States, Germany and the International Monetary Fund.
  • Stock analyst Mary Meeker: "Imagine no Army, Navy, Air Force, Marine Corp or Coast Guard, no federal courts or prisons, no national park service, no Food and Drug Administration, no embassies, no salaries for Congress. That's what it would take to finance the budget by 2025 and still pay interest on America's debts, without either raising revenues or reducing entitlement growth. That's certainly not a recognizable America."

    Buget Cuts

  • Internationally gold’s most direct competitor is the U.S. dollar. Things are changing with the advent of Ben Bernanke’s quantitative easing policies. “It seems the dollar’s safe haven status has vanished, “ says Standard Bank’s Steve Yarrow. “And even for dollar bears like ourselves, this is a worry.”
  • Barrick Gold, the mining giant, has sworn off hedging forever, according to Aaron Regent, the company’s CEO. Barrick, at one time, was the king of forward sellers and a major drag on the price in the 1990s and early 2000s. Seems times have changed. . .
  • Peppering an otherwise bland Academy Awards night, Charles Ferguson, who directed the Oscar winning documentary, Inside Job, said this in his acceptance speech: “Forgive me. I must start by pointing out that three years after a horrific financial crisis caused by massive fraud, not a single financial executive has gone to jail and that’s wrong.” Much of the blame for that lands on the doorstep of the Securities and Exchange Commission which not only did a poor job policing Wall Street before the 2008 meltdown, but compounded its lax approach by failing to bring little more than a slap on the wrist to those responsible. Our good friend, Mr. Stein, has his own view as to what might be going at the SEC.

SEC

  • Recent quote in Financial Times: “Many have been truly shocked by the level of Chinese [gold] buying in the first few weeks of the year. As one senior banker (who is not prone to hyperbole) put it: ‘The demand in China is vast. It's unbelievable. Whatever you think the demand is, it's much bigger ... I'm really staggered.’”..................... “China should increase its gold reserves appropriately, and China must take every chance to buy, especially when gold prices fall," says Li Yinning, government economic advisor. Yinning sees gold as a hedge against the “risks of foreign currency devaluations.” (Read: "Against the devaluation of the U.S. dollar").
  • In a policy change that bodes well for gold as a balance sheet asset, JP Morgan announced last month that it would now accept physical gold bullion as collateral. Remonetization opens up the option of borrowing against one’s gold rather than selling it in order to finance other ventures or investment -- a major development.
  • Eric Roseman (Commodity Trend Alert) agrees with us on the real reason for gold ownership: “It is sometimes easy to forget, with all the euphoria around the price of gold hitting record nominal highs and money being made trading the yellow commodity, the true purpose for holding as part of a diversified portfolio. It is not to crank up your portfolio returns or make you rich over night – leave that to the gold prospectors and miners. The true reason to have gold is an insurance policy. It is there to protect you against world uncertainty and questionable fiat currency. It is a store of wealth not a speculative gamble.” He goes on to put a new twist on the old proverb about gold that it will always buy a quality man’s suit. He stretches the purchasing power argument back to Roman times, saying that an ounce of gold would have purchased “a fine toga, a leather belt and some new sandals.”
  • Egon von Greyerz (Gold Switzerland): “The real move in precious metals is still to come as we have outlined in many articles. Less than 1% of investors own gold. Before this economic cycle is over we are likely to see a mania in physical precious metals that will drive prices exponentially higher. And luckily for investors, this is a mania which is unlikely to end in a collapse since gold most probably will be part of a future reserve currency.”
  • Nothing adds more to gold’s long-term value than the notion that nation-states are likely to accord it a stronger role in central bank (or national) reserves. Where once central banks were net sellers of gold, they are now net buyers. I see this development, in terms of the potential effect on the gold price, as akin to the original Central Bank Gold Agreement, which regulated the flow of gold from the central banks and ignited the now ten-year old bull market. The yellow brick road widens from here.
  • The Royal Mint’s gold and silver coin sales doubled year-on-year in January to 63,000 ounces, lifted in part by the launch of new commemorative coins for the 2012 Olympics and the Royal engagement, the Mint said. Demand for gold coins has risen sharply in recent years as investors have turned to bullion as a hedge against currency market instability and economic turmoil.”
  • Utah’s legislature passed a bill making gold and silver legal tender. It awaits the governor’s signature. This is the first time in over 75 years that gold and silver might be recognized once again as money that can be used in transactions instead of the dollar at the parties’ discretion. Similar proposals have been introduced in Colorado, Georgia, Indiana, Iowa, Missouri, Montana, New Hampshire, Oklahoma, South Carolina, Tennessee, Vermont and Washington. They reflect growing concerns about the dollar -- something we have talked about for decades. It is rewarding to see the interest in gold as a safe haven and asset of last resort taking root in the political sector. Think what such a development might mean for you as a gold owner. The more usage gold receives in commerce, the greater the demand for the physical coinage overall. There may come a time when transacting gold for a piece of land, for example, might create a discount, as gold would be the preferable savings instrument (Gresham’s Law). We will monitor these developments with much interest.
USAGOLD Bulletin Board
  • SILVER BULLION COINS are hot. There was a time when silver represented a very small part of our overall volume. Things have changed. Over the past several months silver sales have grown to represent about a third of our placements with clientele. Most of those purchases have been in the form of bullion coins minted by the United States and Canadian mints. Both are reporting problems getting one-ounce blanks and wholesale premiums are rising in response -- nearly 50¢ per ounce over the past month alone. Due to our strong relationships with various well-capitalized and situated vendors, we have had no difficulty filling orders thus far.
  • JANUARY GOT OFF TO A SLOW START, but February and the first part of March (when this being written) have been nearly as busy as the hectic time after the 2008 financial market meltdown.
  • We invite you to visit the updated USAGOLD website. The header has a much sharper look with a new easy-to-use links table. Also we have updated several of the pages to reflect changes in the gold market. We have always emphasized content at our website. Our goal is make it something worth visiting on a daily basis.

  • Our on-going effort has been rewarded with thousands of visits daily, many of them first-timers. When Google changed its algorithms (in response to the JCPenney scandal), our very strong performance level on most gold-related searches was unaffected. We believe the reason for this is our strong content geared to both newcomers and our regular clientlele.

  • The premiums on pre-1933 gold coins have held steady despite the strong early-year demand. The flow of gold coins from Europe is steady though diminished. European interest has grown markedly due to its sovereign debt crisis -- a problem not likely to disappear anytime soon. If you are looking to increase your pre-1933 gold coin holdings, we recommend that you get the job done before something happens to drive premiums higher and dry up the supply. It doesn’t take much in this thin market to create supply bottlenecks and a spike in premiums.

  • We can help you put gold and silver in your retirement plan or IRA -- efficiently and safely. We have a large number of clients who have done just that over the years and are glad they did. Be careful of the firms that try to talk you into putting contemporary bullion coins, graded at one of the coin services and sold at heavy mark-ups, into your retirement plans. There is nothing special about “first strike” coins. Nor is there anything special about contemporary bullion coins graded Mint State (or Proof) 69 or Mint State (or Proof) 70 -- despite the hype. The best course of action is to stick with the ungraded, contemporary bullion coins or bullion bars that trade at moderate premiums over the gold price.

  • LLOYD’S ASSETWATCH SURVEY recognized gold as the top-performing investment for the fourth time in the past five years. It recommends British Sovereigns “as the best bet” among gold coins. We place thousands of pre-1933 British Sovereigns annually.

  • One of the major new developments for us over the past two or three years is the number of well-capitalized family trusts now balancing their portfolios with gold. CNBC’s James Kramer recently endorsed a 20% diversification with gold. We recommend a 10% to 30% diversification depending upon your level of concern.

  • The Better Business Bureau’s rating system and what it takes to maintain an A+ rating continues to be debated among consumer groups. We maintain an A+ rating, but the real achievement separating us from the pack is that we have zero complaints. Make sure you check the BBB report of any company with which you are thinking of doing business. When you do go beyond the headline rating to assess the number of complaints and what they involved. It can be very revealing, not to speak of helping you stay out of harm’s way.

Disclaimer - Opinions expressed on the USAGOLD.com website do not constitute an offer to buy or sell, or the solicitation of an offer to buy or sell any precious metals product, nor should they be viewed in any way as investment advice or advice to buy, sell or hold. USAGOLD, Inc. recommends the purchase of physical precious metals for asset preservation purposes, not speculation. Utilization of these opinions for speculative purposes is neither suggested nor advised. Commentary is strictly for educational purposes, and as such USAGOLD does not warrant or guarantee the the accuracy, timeliness or completeness of the information found here.


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